Until the last century, Americans generally worked as long as they were able and relied on their families for support in old age. But over the course of the last 100 years, we have gradually come to expect an independent retirement at or around 65 years old. These new expectations are the product of government programs (primarily Social Security) and the defined benefit plans, or pensions that have been widely provided by employers. Pension plans typically reward years of service with secure retirement benefits and, from the employee's perspective, retirement is funded almost invisibly. Employers oversaw the investment of pension funds and assumed the market risk.
Pension plans have several drawbacks for employees and employers alike: the benefits are not portable, and may be lost when an employee leaves the company; employees have no control over or access to their benefits before retirement; the pension fund could fail if the employer becomes insolvent; and the employer's profits include not only the results from business operations but must reflect the employer's pension fund's investment losses as well. In recent decades, “defined contribution” plans have largely displaced pensions. These plans are sponsored by employers but are funded voluntarily by employees. Their strengths include: ease of participation; tax-deferred contributions by employees; full employee ownership (vesting) of their own contributions; portability when changing employment, either to other plans or to Individual Retirement Accounts (IRAs); flexibility in the amount and timing of contributions; borrowing privileges; and choice of investments.
Through defined contribution plans, employees gained ownership and control of their retirement funding, but assumed complete responsibility for saving enough and obtained no shelter from investment risk. Employees like the control, and employers like their reduced responsibility and risk.
A growing number of policy makers see the shift to defined contribution plans as harmful to employees because most save too little, can't adequately forecast how much money they will need, and often manage the investments they do make poorly. Defined contribution plan participants want to know what to expect for income in retirement, but with self-direction they don't know how much to save or how to invest. Retirement calculators have proven ineffective, and investment advisors have not been effective or available to give confidence.
While guaranteed investment products, such as deferred annuities and guaranteed investment contracts, are available today, they are intimidating and complicated from the buyer's standpoint.
Deferred annuity contracts are typically sold in exchange for a lump sum premium, possibly with a contract to make additional payments until retirement, and grow at variable rate (sometimes with partial guarantee of rate) until retirement. Annuity contracts typically make payments for single life, joint life, or for period certain, with other options for minimum payout and recovery of some amount of cash value. While these features are desirable, conventional deferred annuity contracts exhibit most if not all of the following significant disadvantages: the rates of return is either not guaranteed, or guaranteed only for a short term; annuity contracts are typically complex and hard to understand, making it difficult for most investors to make the sound choices needed to properly fund their retirement; annuity contracts are not liquid and may only be exchanged for a sum which is aptly named the contract's “surrender value;” annuity contracts cannot be altered or exchanged to provide a different maturity in case the investor's seeks earlier or later retirement or otherwise changes plans; and annuity contracts are subject to insurance regulations that vary from state to state, adding overhead and complexity.
Note that savings objectives other than retirement funding are well matched to the deferred annuity structure, including education funding. We will also show that estimating the theoretical price and returns of financial instruments in which the purchaser can have a high confidence of a particular or a minimum result is useful in financial planning and in understanding the nature and impact of variable results from riskier investment strategies.
In a defined benefit plan (pension plan), there is a party that implicitly guarantees the performance of the investments set aside to fund the liability represented by the future benefits, and that guarantees the payouts that derive from those investments. The employer or sponsor of the plan expects the value of labor to meet or exceed the total costs of compensation, including the pension plan. In a defined contribution plan, there is no party that will make such guarantees, unless it has a fair chance of making a profit in return for the guarantee. To provide a pension replacement vehicle in a defined contribution plan, you must have a guarantee of a minimum rate of return and a minimum conversion of accumulations to payouts (or in the absence of absolute guarantees, a rate of return and conversion in which you can have high practical or statistically measurable confidence). If you know the minimum return and the minimum conversion, then you can express a target or minimum income that will be provided for any given amount today.
It is accordingly an object of the present invention to combine the best features of defined benefit and defined contribution plans in order to provide secure returns, portability, and access in an investment product that may be readily understood by investors and that provides a defined benefit that is structured to fit easily into defined contribution plans and the channels that market and service those plans.